Bruce Berkowitz on Analyzing Free Cash Flow

Accounting for hidden costs in a cash flow analysis

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Jan 21, 2019
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In an introductory essay to Graham and Dodd’s "Security Analysis, Part IV:Â Theory of Common-Stock Investment. The Dividend Factor," fund manager Bruce Berkowitz (Trades, Portfolio) outlines how he uses free cash flow as a metric for valuation. In it, he explains how he uses the metric and why cash flow is often a superior metric to earnings. First, though, lets recap some basic definitions.

What does it mean?

Recall that free cash flow is calculated by taking the total amount of cash generated by operating activities and subtracting capital expenditures from it. Another way of deriving free cash flow, which perhaps more clearly illustrates its usefulness, is to take net income, add back depreciation and amortization charges and then to subtract capital expenditures and changes in working capital.

So what does free cash flow represent? It is simply a measure of how much money the business is generating right now, after accounting for the costs of maintaining the company’s assets. This money may then be reinvested into the business or distributed to shareholders in the form of share buybacks or dividend payments.

How does Berkowitz derive free cash flow?

Although the formula for calculating free cash flow is relatively straightforward, not everything is as simple as it seems. To quote Yogi Berra: “In theory, there is no difference between theory and practice, but in practice there is.” Berkowitz highlights a few nuances he bears in mind when deriving free cash flow:

“Companies often misstate the costs of employees’ pension and postretirement medical benefits. They also overestimate their benefit plans’ future investment returns or underestimate future medical costs, so in a free cash flow analysis, you need to adjust the numbers to reflect those biases.

Companies often lowball what they pay management. For instance, until the last several years, most companies did not count the costs of stock option grants as employee compensation, nor did the costs show up in any other line item…

Another source of accounting-derived profits comes from long-term supply contracts. For instance, when the now-defunct Enron entered into a long-term trading or supply arrangement, the company very optimistically estimated the net present value of future profits from the deal and put that into the current year’s earnings even though no cash was received. Enron is gone, but not the practice. Insurance companies and banks still have considerable leeway in how they estimate the future losses arising from insured events or loan defaults.”

Is Berkowitz suggesting that companies wilfully engage in accounting fraud? Well, yes, sometimes they do, as was the case with Enron. But more commonly, they will make overly optimistic predictions (in good faith) about their future prospects. Or they will use the gray areas provided by the accounting conventions in order to (legally) present a more positive narrative.

The first takeaway here is to always remember that each company is always going to have its own unique set of financial statements, and that you shouldn’t take every line item at face value. Do not mistake the map for the terrain. The second lesson from this passage touches on the unreliability of earnings as a valuation metric. The truth of the matter is earnings are a lot easier to fudge than cash flow and, as such, should be treated with a healthy dose of skepticism.


Cash flow is a great metric for any value investor, but it has particular significance for dividend investors as free cash flow determines how much money can be paid out to shareholders in the form of said dividends. We will explore this in the future. As with any financial metric, however, when calculating cash flow, you must bear in mind the business may not be accurately estimating its own costs and will need to adjust your models accordingly.

Disclosure: The author owns no stocks mentioned.

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